Washington Analysis Issues Report On Sirius/XM 11-29

REPORT EXCERPT:

We understand yesterday’s weakness in the satellite radio shares stems from what we believe are misplaced concerns about the outcome of the ongoing copyright trial, where a decision on the royalties to be paid the recording labels will be announced by the Copyright Royalty Board (CRB) between December 15thand December 17th. More specifically, webcasters like Yahoo (YHOO-$26), AOL (TWX-$17), etc., were on record yesterday saying they may have to shut down their webcasting music services because of the CRB’s decision earlier in the year that was in line with the recording industry’s demands and resulted in a more than doubling of their costs. We believe investors mistakenly leapt to the assumption that this bodes poorly for the satellite operators. Going unnoticed, in what we believe is a classic case of comparing apples to oranges, is the fact that the two cases are tried using different standards. With the webcasters, it is based on a ‘willing buyer-willing seller’ analysis; with satellite radio, it is more of a ‘fair rate-of-return’ review.

In the current satellite trial, other costs besides royalties must be taken into consideration, such as satellite depreciation, customer service and acquisition costs. It was recently disclosed that Music Choice, which, along with the satellite radio operators, was a party to the ongoing trial, agreed to pay 7.25-7.50% of revenues to SoundExchange, which represents Warner Music Group (WMG-$7), Sony (SNE-$55), Vivendi’s Universal Music and the other recording labels. Since Music Choice has little in the way of ‘other costs’ as it merely passes music along to cable systems’ music channels, it might be argued that 7% should represent a ceiling on what the satellite operators ought to pay. Indeed, according to the analysis submitted by XM (XMSR-$14)-and Sirius (SIRI-$3), when adjusted for their extra costs, their payments should be on the order of 1%. The labels rightly counter that the main reason customers subscribe to cable is for video, not audio services, whereas music is the main driver for satellite radio subscriptions.

For the current period (2007-2012), the satellite companies initially offered 0.88% to the labels while SoundExchange demanded 10%, sliding upwards to 23% in the out-years. The parties recently inched closer, with an offer and ask of 2%+ and 8%+, respectively. While second guessing the CRB represents a high degree of difficulty, we believe the final determination will be approximately 6-7% of revenues. For the labels, this still represents a near tripling from the 2-3% they have received over the past five years on a much smaller revenue base. When added to the payments made to writers and publishers (an estimated 2-3%), who are not part of this trial, total royalties may approximate 10% or less, in contrast with many Wall Street estimates of as high as 15% of revenues. Total royalties (labels, writers, publishers) have recently been on the order of 4%.